Category Archives: Profit & Loss

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In the same radio discussion that I mentioned in my previous post, I heard the radio talk show host say that socialism — and variants of it — has been responsible for millions of deaths and has proven over and over to be a failure. He encouraged the self-described socialist to read some history.

I hear this point made on occasion. I find it frustrating because rarely is it mentioned why socialism fails.

Why does it?

I believe it’s for a couple main reasons.

There’s the knowledge problem. A free market of prices communicates vastly more and better information to allocate resources better than any small group of people can.

I also believe it stifles risky experimentation, which is the source of most innovations, large and small. Without risky experimentation, society rots. I’m not sure, but I think this may actually be a subset of the knowledge problem.

Every human effort is flawed. Failure is not proof of incompetence. So don’t buy the narrative that Mr. Johnson was done in by his hubris and cluelessness about retail. At Sears starting in 1989, a new leader introduced a new strategy of dramatically reduced promotions and manipulative “discounts.” Instead, Sears would feature “everyday low prices,” in-store boutiques and jazzier merchandise. Yes, the same formula. And Mike Bozic lasted the same 17 months that Mr. Johnson did.

I agree that failure is not proof of incompetence. But failure isn’t the reason Johnson has been charged with hubris. It’s not clear to me from Jenkins’ column why we shouldn’t buy the hubris narrative.

Johnson’s hubris was that he made network-wide changes to the business without evidence those changes would help. He never considered that he could be wrong. Some folks like it when someone swings for the fences, but shareholders should be leery when someone comes in with a shoot from the hip attitude. It’s the rare occasion that ends well.

If Johnson’s strategy would have worked across the entire network, it would have worked on a smaller scale, first. He could have made the changes in a market, at much less cost and risk to business. Not testing his ideas first, when he has the ability to do that, is hubris…or stupidity, or a little of both.

Like this:

I wonder if Russ Roberts saw the opinion piece, How to Shrink the “Too-Big-to-Fail” Banks, in Monday’s Wall Street Journal from Richard Fisher and Harvey Rosenblum, who are, respectively, the CEO and Director of Research, at the Federal Reserve Bank of Dallas.

I wonder if Russ Roberts has seen it, because it appears to agree with his hypothesis that a history of government bailout of banks contributed to the financial crisis, because bankers took on more risk than they otherwise would.

Here are Fisher and Rosenblum’s first three paragraphs:

A dozen megabanks today control almost 70% of the assets in the U.S. banking industry. The concentration of assets has been in progress for years, but it intensified during the 2008–09 financial crisis, when several failing giants were absorbed by larger, presumably healthier ones. The result is a lopsided financial system.

Meanwhile, the mere 0.2% of banks deemed “too big to fail” are treated differently from the other 99.8%, and differently from other businesses. Implicit government policy has made these institutions exempt from the normal processes of bankruptcy and creative destruction. Without fear of failure, these banks and their counterparties can take excessive risks.

It also emboldens a sense of immunity from the law. As Attorney General Eric Holder admitted to the Senate on March 6, when banks are considered too big to fail it is “difficult to prosecute them . . . if we do bring a criminal charge, it will have a negative impact on the national economy.”

That last paragraph paints an image for me of the TBTF bankers holding the economy hostage for the taxpayer ransom. I wish I could draw.

Here they sum up the problem rather well:

…market discipline is still lacking for the largest dozen or so institutions, as it was during the last financial crisis. Why should a prospective purchaser of bank debt practice due diligence if in the end, regardless of new layers of regulation and oversight, the issuing institution won’t be allowed to fail?

The return of marketplace discipline and effective due diligence of banking behemoths is long overdue.

In case you are wondering, prospective purchasers of bank debt practicing due diligence is an example of market discipline, just like you practicing due diligence on your car purchase.

Credit Fisher and Rosenblum for going on to offer a solution, which involves rolling back the Federal government safety net and restructuring TBTF banks into entities that can go through speedy bankruptcies so they will be “too small to save”.

Most of us make purchasing and voting decisions. Sometimes they are a little of both, like when you vote with your family on what’s for dinner.

The following are links to and excerpts from previous posts I’ve made quoting economists Thomas Sowell and Walter Williams, who do an excellent job of explaining why purchase decisions are a more effective feedback mechanism than voting.

The fundamental difference between decision-makers in the market and decision-makers in government is that the former are subject to continuous and consequential feedback which can force them to adjust to what others prefer and are willing to pay for, while those who make decisions in the political arena face no such inescapable feedback to force them to adjust to the reality of other people’s desires and preferences.

A business with red ink on the bottom line knows that this cannot continue indefinitely, and that they have no choice but to change whatever they are doing that produces that red ink, for which there is little tolerance even in the short run, and which will be fatal to the whole enterprise in the long run. In short, financial losses are not merely informational feedback but consequential feedback which cannot be ignored, dismissed or spun rhetorically through verbal virtuosity.

In the political arena, however, only the most immediate and most attention-getting disasters — so obvious and unmistakable to the voting public that there is no problem of “connecting the dots” — are comparably consequential for the political decision-makers. But laws and policies whose consequences take time to unfold are by no means as consequential for those who created those laws and policies, especially if the consequences emerge after the next election. Moreover, there are few things in politics as unmistakable in its implications as red ink on the bottom line is in business. In politics, no matter how disastrous a policy may turn out to be, if the causes of the disaster are not understood by the voting public, those officials responsible for the disaster may escape accountability, and of course, they have every incentive to deny having made mistakes, since admitting mistakes can jeopardize a whole career.

2. In three paragraphs that I quoted from Thomas Sowell’s book, Applied Economics, he explains the differences in our buying and voting decisions. Here are those three paragraphs:

Politics and the markets are both ways of getting people to respond to other people’s desires. Consumers deciding which goods to spend their money on have often been analogized to voters deciding which candidates to elect to public office. However the two processes are profoundly different. Not only do individuals invest very different amounts of time and thought in making economic vs. political decisions, those are inherently different in themselves. Voters decide whether to vote for one candidate or another but they decide how much of what kinds of food, clothing, shelter, etc. to purchase. In short, political decisions tend to be categorical, while economic decisions tend to be incremental.

Incremental decisions can be more fine-tuned than deciding which candidate’s whole package of principles and practices comes closest to meeting your own desires. Incremental decision-making also means that not every increment of even very desirable things is likewise necessarily desirable, given that there are other things that the money could be spent on after having acquired a given amount of a particular good or service. For example, although it might be worthwhile spending considerable money to live in a nice home, buying a second home in the country may or may not be worth spending money that could be used for sending a child to college or for recreational travel overseas. One consequence of incremental decision-making is that increments of many desirable things remain unpurchased because they are almost–but not quite–worth the sacrifices required to get them.

From a political standpoint, this means that there are always numerous desirable things that government officials can offer to provide to voters who want them–either free of charge or at reduced, government-subsidized prices–even when the voters do not want these increments enough to sacrifice their own money to pay for them. The real winners in this process are politicians whose apparent generosity and compassion gain them political support.

3. In his classic column, Conflict or Cooperation, which I linked to in this post, Walter Williams explains how to pit beer drinkers against wine drinkers. Here’s a taste:

Different Americans have different and often intense preferences for all kinds of goods and services. Some of us have strong preferences for beer and distaste for wine while others have the opposite preference — strong preferences for wine and distaste for beer. Some of us hate three-piece suits and love blue jeans while others love three-piece suits and hate blue jeans. When’s the last time you heard of beer drinkers in conflict with wine drinkers, or three-piece suit lovers in conflict with lovers of blue jeans? It seldom if ever happens because beer and blue jean lovers get what they want. Wine and three-piece suit lovers get what they want and they all can live in peace with one another.

It would be easy to create conflict among these people. Instead of free choice and private decision-making, clothing and beverage decisions could be made in the political arena. In other words, have a democratic majority-rule process to decide what drinks and clothing that would be allowed. Then we would see wine lovers organized against beer lovers, and blue jean lovers organized against three-piece suit lovers. Conflict would emerge solely because the decision was made in the political arena. Why? The prime feature of political decision-making is that it’s a zero-sum game. One person’s gain is of necessity another person’s loss. That is if wine lovers won, beer lovers lose.

The differences in political and private decisions has spawned a branch of economics study called public choice economics. Here’s more.

My business school professor: Wrong! To maximize shareholder value. You could please customers by giving your product away for free, but that wouldn’t please your shareholders.

Me: With all due respect, it wouldn’t please your customers for very long if you go out of business by giving away your product for free — especially if they value your product, now would it?

My business school professor: [This-discussion-is-over glare] [Proceed to explain why maximizing shareholder value is the key goal of a firm].

I never bought the ‘maximize shareholder value’ credo, or at least the moronic behavior it led to. I do believe it is the manager’s job to maximize shareholder value, but I never believed that was the goal. Rather, it is a result of pleasing customers.

I’ve seen too many short-sighted decisions come from the ‘maximize shareholder value’ mantra because the customer was left out of the equation.

Although Jack Welch was seen during his tenure as CEO of GE as the heroic exemplar of maximizing shareholder value, he came to be one of its strongest critics. On March 12, 2009, he gave an interview with Francesco Guerrera of the Financial Times and said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal. … Short-term profits should be allied with an increase in the long-term value of a company.”

I remember one example of this short-sighted focus on shareholder value when I as an engineer for a utility company. One of our big industrial customers — infected by the shareholder value mantra — approached us seeking to buy the electrical facilities at their plant. We delivered power to them at the low voltage they needed to run their equipment. We also had special switchgear at their site — that we owned — to provide the volume and reliability they needed. We charged them extra for this enhanced service.

They computed the simple math of the cash outlay to buy the equipment from us, the fees that would save them and the cost they thought it would take to maintain the equipment. I saw their analysis. On paper it looked like a good investment, one that would add to their shareholder value by reducing costs and increasing profits.

But, their experience was different. They quickly learned that the higher fees they use to pay us included something they didn’t have — expertise and opportunity cost. They realized that trying to figure out how to maintain electrical switchgear took time away producing the products they made for their customers.

They first hired us back to maintain the equipment and then eventually sold the equipment back to us and ‘got out of the business of maintaining electrical switchgear’ so they could again focus on delivering value for their customers.

1. From A Stingy Spirit Lifts Airline’s Profit, on the success of low-budget flyer Spirit Airlines. Most Chief Executives want to own the market. You don’t often hear a Chief Executive who knows the value prop that his business delivers:

Banks that refrain from risk aren’t banks. And expecting regulators to distinguish good hedges from “risky bets,” as Volcker [rule] requires, is to expect regulators to be better bankers (for a lot less pay) than one of the best bankers, Mr. Dimon, has shown himself to be.

Borrowers who have recently applied for a mortgage know how thorough lenders are now in documenting a person’s finances and ability to repay.

A big reason lenders are being careful is that they fear they’ll have to buy back loans from Fannie Mae or Freddie Mac if proper underwriting standards aren’t adhered to and the loans go bad after being securitized by one of the government-sponsored enterprises…

As Russ Roberts says, “Capitalism is a profit and loss system. Profits encourage risk-taking. Losses encourage prudence.”Amazingly, when you put the incentive of losses back in the system, prudence increases.

Company managers love to chase market share. They like it because it’s a competitive head-to-head score, like a score to a baseball game. If you “take” market share from your competitors, then you’re beating them up and that’s good. If they take it from you, that’s bad.

I don’t think we should worry much about market share. I have several reasons.

First, it isn’t necessarily a good read on the measure of business health.

Consider a simple ad absurdum: Would you be better off by doubling market share by cutting price in half?

No. You may be worse off. What if you cut your salary in half and got two jobs?

Sure with more clients, you’re less dependent on any one client. But, it will cost twice as much to serve those clients. So, you’ve doubled your costs while keeping revenue flat. And, you may have attracted a less loyal client that is more likely to leave you.

Several years ago, a company I worked with exited a line of business that had given it some market share and consistent financial losses for six years. It showed no signs of producing profits. There’s another name for such a line of business: unnecessary cost.

The managers kicked themselves on the earnings conference call for losing that market share. Rather than kicking myself, I would’ve celebrated giving up that line because it would mean getting rid of an unnecessary cost and more money for shareholders.

Getting rid of unprofitable market share, as in the example above, can be good. Acquiring unprofitable market share can be bad.

Earnings is a better measure of health.

Second, focusing on market share keeps managers too focused on their existing product lines. The best makers of buggy whips probably acquired significant share of the buggy whip market as the automobile was replacing the buggy.

Third, the “market” is to easy to get wrong. Is McDonald’s market share its share of hamburgers sold, its share of fast food hamburger restaurant sales, its share of fast food restaurant sales, its share of all restaurant sales or its share of all food and beverages sold?

Why pick one definition over the other? Should McDonald’s be bothered that you chose to buy a Coke at the vending machine in your office building instead of one its restaurants? Should they get into the office vending business in order to “capture” that market share?

I don’t think so.

Fourth, the market share paradigm turns the business world into a caricature of a “battle for control of the market”. Company managers even try to act like that’s how it works as they bludgeon their troops to deliver results.

I think that’s an inaccurate and damaging representation of the business world.

Companies that gain profitable market share are those that provide products that clients value enough to buy at a price that more than covers the company’s costs.

Rather than a heartless battle for market share, the business world is really a trial-and-error lab that looks for ways to delight customers. Rather than Glengarry Glen Ross, it’s more like Starbucks.

Rather than gaining market share, businesses should be focused on pleasing customers and growing profits.

Growing profits is less like war and more like convincing a girl to go on a date. The secret to doing that is to give a girl what she wants. Figuring out what that is a trial-and-error process and can change at any time.